Unit

3
Audit Process

Overview

Audits are conducted in a structured way to ensure that the relevant processes, risks and
controls are captured and addressed adequately. There are different phases of an audit
starting with the engagement formalities and ending with the final audit report, which is
the primary deliverable of the audit. The intermediate phases of the audit are planning,
fieldwork and completion/ conclusion. Different writers will break out these phases
differently but basically all audits will have these five phases. In this unit we will explore
the different phases and the audit work done at each level.

Unit 3 Learning Objectives

At the end of this unit you should be able to:

1. Understand the chronology of an audit
2. Appreciate what happens at the different stages of the audit process

There is one session in this unit:

Session 3.1: The Audit Process

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 USEFUL LINK/RESOURCES/READING
Online Resources
7 Major Phases of Audit of Financial Statements
http://accounting-financial-tax.com/2009/09/7-major-phases-of-audit-of-financial-statements/

Videos
The Audit Process
http://www.youtube.com/watch?v=M4KODhNVoo4&feature=related

The Audit Process

http://www.youtube.com/watch?v=1yo3GyvZi9Q&feature=related

Terms of Use: You are reminded to respect and observe the copyright and terms of use indicated
for all of the websites to which you are being directed for readings.

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Session 3.1

The Audit Process

Introduction
Statutory audits are required by the auditing standards and guidelines to be conducted
in chronological order beginning with the engagement exercise and ending with the
presentation of the audit report to the members of the organisation, expressing an opinion
on the truth and fairness of the financial statements. The auditor is required to carry out
such work as is necessary to ascertain if:
• Proper accounting records have been kept
• The financial statements are in accord with the underlying records
• The financial statements have been prepared in accordance with applicable legislations
and regulations
• The financial statements represent a true and fair view of the financial position of
the entity at the date of the report and the financial performance of the entity for the
period being reported on.

The main activities of the audit are:

• Gaining an understanding the client’s business, including processes and procedures
for capturing, storing, processing, reporting and disseminating information
• Testing the efficiency and effectiveness of the accounting systems as the basis for the
preparation of financial statements
• Testing the transactions and balances reported in the financial statements for agreement
with the accounting records and compliance with relevant legislations and regulations
• Checking the financial reports for proper presentation and adequate disclosure of
material facts

In this session, we will provide an overview of the different stages of the audit which will
be looked at in greater details further on the course.

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 Key Terms
Audit Procedure – Detailed instruction for the collection of a type of audit evidence
Analytical Procedures – Use of comparisons and relationships to assess whether account
balances or other data appear reasonable
Compliance Test – Audit procedures to test the effectiveness of controls
Substantive Test – Audit procedures testing for monetary misstatements to determine
whether the audit objectives for the balance or transaction have been satisfied
Control risk – The risk that a material misstatement could occur in a relevant assertion
and not be prevented or detected on a timely basis by the entity’s internal control.
Inherent risk – The susceptibility of a relevant assertion to material misstatement, assuming
that there are no related controls. 

Audit Approaches
There are different approaches to conducting an audit, which will determine the starting
point and the path to be taken in achieving the audit objectives. Pine (2008) identifies 4
different auditing approaches as follows:
1. The substantive procedures approach
2. The balance sheet approach
3. The systems-based approach
4. The risk-based approach

The selection of the audit approach influences the nature of the audit work and the audit
evidence as well as the result of the audit.

ACTIVITY 3.1 •

Do an online search on the four approaches to audits listed above under “Audit Approaches”.

Make notes on the different approaches including the starting point, the process and the
circumstances under which they may be used. Identify differences and similarities between
the different approaches.

Share the results of your research in the discussion forum.

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 Stages of an Audit
There are different phases in the audit process. The major phases are engagement
planning, fieldwork and completion. Different authors will classify the activities into
different groupings, without any significant differences in the activities. Millichamp (2002)
classified the various stages of an audit as follows:
1. Background research
2. Preparation of the audit plan
3. Accounting system review
4. Internal control system review
5. Substantive testing
6. Analytical review techniques
7. Analytical review of financial statements
8. Preparation and signing of the audit report

These steps may be broken out into even more stages; there is no right or wrong classification
of activities. The important thing is to capture all the relevant activities involved.

Audit Planning
The first stage of an audit is to agree on the terms of engagement and define the scope of
the audit, which will determine the objectives of the audit, the nature of audit evidence
and the work necessary to accomplish such objectives. The output at this stage is an
engagement letter, which outlines the terms of the audit engagement.

Having agreed the terms of the audit engagement the next step is the gathering of
preliminary data on the organization and its environment sufficient for the auditor to
gain an understanding of the client’s business and the key factors influencing it. This will
assist in identifying areas of significance to be audited, specifically, classes of transactions,
account balances, and disclosures that might be materially misstated. The auditor
performs risk assessment to obtain evidence on potential risks of material misstatement
to guide their audit work. This approach is referred to as risk-based auditing – it is based
on the premise that it is not necessary for the auditor to perform detailed work in all areas
but may limit their work to high risk areas; this being sufficient to provide reasonable
assurance (absolute assurance is not required).
The risks of material misstatement consist of:
• Inherent risk: The susceptibility of a relevant assertion to material misstatement,
assuming that there are no related controls. 
• Control risk: The risk that a material misstatement could occur in a relevant assertion
and not be prevented or detected on a timely basis by the entity’s internal control.

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 Inherent risk relates to the business the organization is involved in and the environment
in which it operates. It also incorporates the possibility of material misstatement due
to fraud, and significant measurement uncertainty in accounting estimates and in non-
routine transactions. Auditors must attain sufficient background information on the client
to assess the risk of material misstatement of the financial statements and to design the
nature, timing, and extent of further audit procedures. Risk assessment procedures are
used here and include inquiries of management and others within the entity, analytical
procedures, observation and inspection, and other procedures.

ACTIVITY 3.2 • Dlscussion

A risk in using “risk-based auditing” is that if the auditor applies a wrong rating in assessing
particular risks, sufficient audit evidence may not be obtained to provide reasonable
assurance on those areas. Using the scenario outlined below:
• Identify the business risks faced by ABC Ltd
• What rating would you apply to each risk? Why?
• How would this impact the audit work to be done?
Discuss your responses with your colleagues in the discussion forum. State any assumptions
you make.

Scenario: ABC Ltd.

ABC Ltd.’s principal business activity is the assembly of circuit boards. One of the key
materials used is copper wiring, all of which is imported. As a cost cutting measure, a
contract with a new overseas supplier was signed, and all of the company’s copper wiring
is now supplied under this contract. Purchases are denominated in a foreign currency, but
the company does not use forward exchange contracts in relation to its imports of copper
wiring. The company has two production facilities, one of which produces goods for the
export market, and the other produces goods for the domestic market. About half of its
goods are exported, but the export market is suffering due to competition from cheaper
producers overseas. Most domestic sales are made under contract with approximately 20
customers.

In October 2012, production was halted for a week at the production facility which supplies
the domestic market. A number of customers had returned goods, claiming faults in the
circuit boards supplied. On inspection, it was found that the copper used in the circuit
boards was corroded and therefore unsuitable for use. The corrosion is difficult to spot as
it cannot be identified by eye, and relies on electrical testing. All customers were contacted
immediately and, where necessary, products recalled and replaced. The corroded copper
remaining in inventory has been identified and separated from the rest of the copper.

Several of ABC Ltd’s key management personnel left in October 2012, to set up a
company specialising in the recycling of old electronic equipment. This new company is
not considered to be in competition with ABC’s Ltd operations.

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 Control Risk
We will now look at control risk which is the risk that a material misstatement could occur
in a relevant assertion and not be prevented or detected on a timely basis by the entity’s
internal control. Having assessed the client’s business risk, the next stage for the auditor
is to ascertain and evaluate the client’s accounting system and the system of internal
controls in place as the basis for preparation of the financial statements. This allows the
auditor to identify areas that may be misstated and to design other procedures based on
characteristics of the existing system.

After analyzing the design and implementation of internal control, the auditors must
decide whether the system appears adequate to prevent or detect and correct material
misstatements.
Based on the assessed risks of misstatement for various transactions, account balances, and
disclosures, and on various requirements to perform certain audit procedures regardless of
the individual company risk assessment, the auditors will design and perform substantive
procedures to test the accounting records.

Audit planning involves developing an overall strategy for performing the audit. The
document produced at the end of this stage is the audit planning memorandum which
states the nature of the planning activities performed, the findings, risk assessment
analysis, internal control and the audit prorammes.

Testing the Financial Statements

The testing for agreement with accounting records and compliance with legislation and
regulations is the next step. Having completed the planning, the auditor will execute
through the performance of substantive tests, the assertions on transactions and balances.
At this stage the auditor will agree on the financial statements to the underlying records.

Substantive procedures restrict detection risk, the risk that audit procedures will incorrectly
lead to a conclusion that a material misstatement does not exist in an account balance when
in fact such a misstatement does exist. While tests of controls, as noted above, provide
evidence as to whether controls are operating effectively, substantive procedures provide
evidence as to whether actual account balances are proper. 
Having completed the necessary tests, the auditor will perform an analytical review to
guide them in assessing conclusions reached and for evaluating overall financial statement
presentation.

Audit Report
Final decisions are made as to required financial statement disclosures and as to the
appropriate audit report. This is the audit report. A standard unqualified audit report is
issued by the auditor when their examination and the results thereof are satisfactory. This
standard unqualified report is modified as the audit examination deviates from normal,
or as the financial statements fail to comply with generally accepted accounting principles
(GAAP).

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 ACTIVITY 3.3 • Watch Video
 
Copy and paste the following link to access a video on the audit process.

The Audit Process

http://www.youtube.com/watch?v=1yo3GyvZi9Q
The Audit Process
http://www.youtube.com/watch?v=M4KODhNVoo4&feature=related

You should now have an overview of the audit process. We will now do a short case study
to wrap up this unit.

ACTIVITY 3.4 • Discussion

Techi’s Ltd is a computing company making, importing and retailing computers and computer
software. They have several branches internationally. Sales have been good until recently
when since the recession they have suffered from falling sales and excess stocking of out
dated hardware and software. They have managed to stay afloat by cutbacks and reducing
staff levels, both operational and managerial.

1. What are the stages required in the audit of Techi’s Ltd?

2. Outline these clearly and explain each one.

Session 3.1 Summary

In this session we have covered the different stages of an audit and the audit process that
will be covered at each stage. In the upcoming units we will examine each stage in more
detail beginning with audit reporting.

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 References
7 Major Phases of Audit of Financial Statements
http://accounting-financial-tax.com/2009/09/7-major-phases-of-audit-of-financial-
statements/

Pine, B. (2008). A Risk-Based Approach To Auditing Financial Statements. Retrieved from

http://www.accaglobal.com/content/dam/acca/global/PDF-students/2012s/sa_
feb08_pine.pdf

Millichamp, A.H. Auditing. (2002). London: Continuum International Publishing Group.

Video

The Audit Process

http://www.youtube.com/watch?v=M4KODhNVoo4&feature=related

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